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Resource Accounting in Measures of Unsustainability

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Environmental and Resource Economics 15: , Kluwer Academic Publishers. Printed in the Netherlands. 257 Resource Accounting in Measures of Unsustainability Challenging the World Bank s
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Environmental and Resource Economics 15: , Kluwer Academic Publishers. Printed in the Netherlands. 257 Resource Accounting in Measures of Unsustainability Challenging the World Bank s Conclusions ERIC NEUMAYER Department of Geography and Environment, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, UK ( Accepted 22 January 1999 Abstract. The World Bank has recently published a comprehensive study of environmental and resource accounting, covering 103 countries (World Bank 1997a). The study concludes that many Sub-Saharan, Northern African and Middle East countries have had negative genuine saving rates over the last 20 years and therefore fail to pass the test of weak sustainability. This paper argues that the Bank s conclusions depend on a method for computing user costs from resource exploitation that is challenged by two competing ones (the El Serafy -method and the method of Repetto et al.) and is inferior to one of its rivals. Resource rents are re-computed using the El Serafy -method for 14 countries and the Sub-Saharan and Northern African and Middle East regions. The results are that both regions and almost all countries either stop exhibiting signs of unsustainability or their unsustainability can be explained without having recourse to resource accounting. However, for Congo, Ecuador, Gabon, Nigeria, Mauritania and Trinidad and Tobago there is a lesson: These countries did not adequately use the opportunities they were given through their natural resource endowments and should learn from their mistake for the future depletion of their remaining reserves of natural resources. Key words: accounting, El Serafy -method, genuine savings, natural resources, pollution, sustainability, World Bank JEL-classification: E22, O13, Q32, Q43 Abbreviations: ENetS Extended Net Saving; EGS II Extended Genuine Saving II; EGS II (World Bank) Extended Genuine Saving II using the World Bank method; EGS II (El Serafy) Extended Genuine Saving II using the El Serafy -method with discount rate 4% p.a.; EGS II (El Serafy 10% p.a.) Extended Genuine Saving II using the El Serafy -method with discount rate 10% p.a. 1. Introduction If sustainability is defined as the capacity to provide non-declining future welfare then, clearly, a reliable measure of sustainability would be of great policy usefulness. In recent years, several studies have been undertaken claiming to provide an admittedly crude measure of weak sustainability for single countries or a selection of countries e.g. Repetto et al. (1989) for Indonesia, Repetto and Cruz (1991) 258 ERIC NEUMAYER for Costa Rica, van Tongeren et al. (1993) for Mexico, Bartelmus et al. (1993) for Papua New Guinea, Serôa da Motta and Young (1995) for Brazil, and Pearce and Atkinson (1993), and Hamilton and Atkinson (1996) for several countries. The term weak refers to the fact that, often implicitly, perfect substitutability between man-made, natural and other forms of capital is assumed in both production and utility functions. World Bank (1997a) is the most comprehensive of these studies, covering 103 countries in total over a period of 25 years. It suggests that the world taken together as well as the high-income countries are safely weak sustainable due to high investments in man-made and human capital. It also suggests that most Sub-Saharan countries and the whole region show signs of unsustainability during the 1980s and 1990s. The same is true for some North African and Middle East countries and the region as a whole who fail to pass the test of weak sustainability from the early 1970s onwards. This paper critically examines the World Bank (1997a) study. It shows that the Bank s rather strong conclusions crucially depend on a method for computing resource rents that is one of at least three competing ones and is inferior to one of its rivals. Using the so-called El Serafy -method to compute resource rents leads to opposite conclusions for both regions and indeed for most countries that fail to pass the test of weak sustainability according to World Bank (1997a). Thus it is demonstrated that the study does not provide a reliable sustainability indicator and will lead to wrong policy conclusions. The paper is organised as follows: Section 2 describes the structure of the data and the main conclusions of World Bank (1997a). It also states the welfare theoretic foundations for the Bank s genuine savings indicator of unsustainability. Section 3 discusses competing methods for computing resource rents and argues why using the El Serafy -method is preferable to the Bank s method. Section 4 undertakes empirical sensitivity analysis in computing resource rents according to the El Serafy -method in the calculation of genuine savings for those countries that appeared to be unsustainable according to World Bank (1997a). It shows that the Bank s conclusions are largely reversed if this competing method is used. Nevertheless, a few countries keep on exhibiting signs of unsustainability. For these countries in particular section 5 discusses policy implications. Section 6 concludes. 2. The World Bank Study The data set underlying World Bank (1997a) consists of savings and accompanying data (World Bank 1997b). Of special interest here is what the Bank calls Extended Genuine Saving II (EGS II): gross domestic investment minus net foreign borrowing plus net official transfers plus education expenditures minus depreciation of man-made capital minus resource rents from the depletion of natural resources minus damage caused by CO 2 -emissions as a proxy for other pollutants. 1 Current educational spending (e.g. teachers salaries, expenditures on RESOURCE ACCOUNTING IN MEASURES OF UNSUSTAINABILITY 259 textbooks) is considered as an investment in human capital, rather than consumption as in the traditional national accounts. The difference is relevant, since current expenditures make up more than 90% of all educational expenditures (World Bank 1997a, p. 34). For the computation of natural resource rents Word Bank (1997a) includes the following items: oil, natural gas, hard coal, brown coal, bauxite, copper, iron, lead, nickel, zinc, phosphate, tin, gold, silver and forests. Rents are usually computed as price minus average costs times production/harvest, i.e. they are valued at so-called total Hotelling-rent where the more readily available average costs are used as a proxy for the theoretically correct marginal costs. The only pollutant considered are CO 2 -emissions which are valued at 20 US$ per metric tonne of carbon. The value is taken from Fankhauser (1995) and is often regarded as a consensus estimate. 2 Of all the data underlying World Bank (1997a) EGS II is closest to a broad measure of weak sustainability. This result can be derived from dynamic optimisation models as, e.g., in Hamilton (1994, 1996) and Neumayer (1999). While Asheim (1994) and Pezzey and Withagen (1995) have shown that positive genuine saving rates are only a necessary, but not sufficient condition for weak sustainability, persistently negative rates of genuine saving must lead, eventually, to declining well-being (World Bank 1997a, p. 28). Note that because of the underlying optimisation framework efficient resource pricing according to the Hotelling (1931) rule is implicitly assumed: resource rent rises over time at the rate of interest. This leads to some modifications for the keep genuine savings above zero rule for an open economy (Hartwick 1996; Asheim 1996). With marginal extraction costs not falling at a rate higher than the interest rate, future resource prices will be higher than current ones, thus providing the resource exporter with improving terms-of-trade. Due to that, the exporter of natural non-renewable resources can have negative genuine savings and still ensure sustainability. The resource importer, on the other hand, faces a future deterioration in her terms-of-trade, so she must save more than would be the case in a closed economy. That is, it is on the non-renewable resource importer to make an extra-adjustment for the growing scarcity of the resource. In World Bank (1997a) no correction term for anticipated price changes is included on either the resource exporter s or importer s side, however. The reason is presumably that the authors consider empirical support for efficient resource pricing to be rather weak and are unsure about the future development of actual net resource prices, so that as a default rule of thumb for sustainability, simply investing current resource rents is likely to be the prudent course of action (Hamilton and Atkinson 1996, p. 4) for both importers and exporters. 3 This disregarding of future price changes is problematic because it contradicts the underlying dynamic optimisation assumptions which were necessary to provide the sustainability foundations of genuine savings in the first place. World Bank (1997a) assigns all damage from CO 2 to the emitting country. This allocation rule is not compelling. Damage from global warming is caused by 260 ERIC NEUMAYER the accumulated stock of CO 2 and other greenhouse gases. Developing countries could make a point in claiming that their incremental CO 2 -emissions should count less than those from developed countries considering the already existing stock of CO 2 in the atmosphere mainly due to developed country emissions. A closer inspection of the data in World Bank (1997b) reveals, however, that damage from CO 2 -emissions plays a negligible role in bringing EGS II rates 4 down below zero. I therefore do not undertake sensitivity analyses for damage from CO 2 -emissions. The years covered in World Bank (1997a) are 1970 to 1994, for some countries only up to The data set includes 103 countries, which are grouped into income and regional groups (see World Bank 1997b). None of the former or current communist countries is included, for lack of data with acceptable quality. Some of the very small countries are missing as well. Appendix 1 indicates which countries had certain ranges of years with negative EGS II rates. Figure 1 shows EGS II rates for four different income groups and the world taken together. 5 Keeping in mind that where genuine saving is negative, it is a clear indicator of unsustainability (World Bank 1995, p. 53), it is apparent that for the world taken together and the high income countries in particular there is no indication of unsustainability. All of the other three income groups experience a few years with negative rates, most notably the group of lower middle income countries. The rates are only slightly negative, however, and they are not persistent in the sense that they become positive again in the early and mid-1980s and reach their former level in the early 1990s. It can be concluded therefore that at this level of aggregation no clear signs of unsustainability are apparent. Figure 2 shows EGS II rates for a selection of five different regions. The highest rates are achieved in East Asia where they usually fluctuate between 10% and 20%. South Asia s EGS II rates are relatively constant around 6 7% and never go negative. For the Caribbean and Latin America the rates decline from 10% in the late 1970s to just below 0% in 1983 from where they have risen again to just over 5% in More problematic is the region of Sub-Saharan Africa. Its EGS II-rate declined from around 5% in the late 1970s to become negative in 1979, slightly positive in 1980 and turned negative again afterwards where it has stayed for the rest of the period, fluctuating around 5%. Still more problematic is the region of North Africa and Middle East. This region experienced positive rates only in 1972, 1973 and During the late 1970s and early 1980s it exhibited rates drastically lower than 10%, reaching its climax in 1979 with almost 30%! If persistent EGS II rates are a clear indicator of unsustainability, then Africa and the Middle East appear to be on an unsustainable path. To analyse what drives EGS II rates to become negative it is best to disaggregate the data still further and look at individual country experiences. I decided, somewhat arbitrarily, to translate persistently negative rates into having experienced negative rates for more than 10 years in the period though not necessarily in a row. 24 out of the total of 103 countries were unsustainable thus defined. RESOURCE ACCOUNTING IN MEASURES OF UNSUSTAINABILITY 261 Source: Own computations from World Bank (1997b). Figure 1. Extended Genuine Saving II rates for income groups. For 5 out of these 24 countries Chad, Madagascar, Malawi, Sierra Leone and Uganda the EGS II rates are very close to and move very closely with the Extended Net Saving (ENetS) rates, where ENetS is defined as gross domestic investment minus net foreign borrowing plus net official transfers minus depreciation of man-made capital plus education expenditures. For these countries, therefore, unsustainability can already be explained without having recourse to taking natural capital into account: they are on an unsustainable path because they eat up their stock of man-made capital. Even taking ENetS as an indicator would detect these countries as unsustainable and looking at EGS II instead would not give major new insights. These countries are therefore excluded from the further analysis. 3. Competing Methods for Computing Resource Rents Of particular interest is what drives the EGS II rates below ENetS rates for the other countries. Since ENetS minus rents from natural resource depletion minus (negligible) damage from CO 2 -emissions equals EGS II, we have to examine in more detail how the numbers for resource rents are generated. 262 ERIC NEUMAYER Source: Own computations from World Bank (1997b). Figure 2. Extended Genuine Saving II rates for regions. The Bank values resource rents to be deducted from ENetS as (P AC) R (1) where P is the resource price, AC is average cost and R is resource depletion. Note that (1) roughly corresponds to total Hotelling rent, except that the more readily available average costs are used instead of marginal costs. Resource discoveries do not enter the formula. The Bank values discoveries at average discovery costs which are used as a more readily available proxy for marginal costs. Since exploration expenditures are treated as investment in standard national accounting (World Bank 1997a, p. 28) already anyway, there is no correction term for discoveries. The Bank s method to compute resource rents is just one of at least three. The others I look at here are the so-called El Serafy -method (El Serafy 1989, 1991) and the method of Repetto et al. (Repetto et al. 1989, Repetto and Cruz 1991). The formula for the method of Repetto et al. is: (P AC) (R D) RESOURCE ACCOUNTING IN MEASURES OF UNSUSTAINABILITY 263 where D is resource discoveries. Note that in this method resource discoveries are valued at P AC, i.e. at net profits and that the correction term can be positive if D R in the accounting period. Efficient resource pricing according to Hotelling s rule is implicitly assumed. Also note that, strictly speaking, exploration expenditures should be netted out from NNP, if this method is used, in order to avoid partial double counting of resource discoveries. The formula for the El Serafy -method is: [ ] 1 (P AC) R (1 + r) n+1 where r is the discount rate and n is the number of remaining years of the resource stock if production was the same in the future as in the base year, i.e. n is the static reserves to production ratio. If r 0andn 0, then (2) will produce a smaller deduction term for resource depletion than (1). (2) is also called the user cost of resource depletion since it indicates the share of resource receipts that should be considered as capital depreciation. Note that no explicit correction term for resource discoveries is needed in this method since discoveries enter the formula via changing n and the formula is computed anew for each year. The formula for the El Serafy -method is derived from the following reasoning: receipts from non-renewable resource extraction should not fully count as sustainable income because resource extraction leads to a lowering of the resource stock and thus brings with it an element of depreciation of the resource capital stock. 6 While the receipts from the resource stock will end at some finite time, sustainable income by definition must last forever. Hence, sustainable income is that part of resource receipts which if received infinitely would have a present value just equal to the present value of the finite stream of resource receipts over the life-time of the resource. Defining resource receipts RC as RC (P AC) R, then the present value of resource receipts RC at the constant discount rate r over the expected life-time n of the resource stock is equal to: [ ] 1 n RC 1 RC (1 + r) = n+1 (1 + r) i 1 1. (3) 1 + r i=0 The present value of an infinite stream of sustainable income SI is i=0 SI SI(1 + r) = = (1 + r) i r SI r (2). (4) 264 ERIC NEUMAYER Setting (3) and (4) equal and rearranging expresses SI as a fraction of RC: 7 [ ] 1 SI = RC 1. (5) (1 + r) n+1 The correction term, representing user cost or the depreciation of the resource stock, would thus be [ ] [ ] 1 1 (RC SI) = RC = (P AC) R (1 + r) n+1 (1 + r) n+1 which is the formula in (2). An estimate of the life-time of the resource, n, thatis the static reserves to production ratio is required. The El Serafy -method does not presume efficient resource pricing resource rent growing at the rate of interest according to Hotelling s rule, because it is not dependent on an optimisation model. It is an ex post approach, capable of accounting for any entrepreneurial decisions regarding extraction (El Serafy 1997, p. 222). As a consequence future resource receipts have to be discounted and the El Serafy -method requires the selection of a discount rate r. If either the life-time of the resource asset, n, orthe discount rate r are quite large, the necessary correction term will consequently be rather small (see equation (2)). Also note that the correction term can never be positive. Which method for computing natural resource rents should be preferred? Both the World Bank s method and the method of Repetto et al. can be derived from a dynamic optimisation model. The difference is that to arrive at the World Bank s method expenditures for resource exploration are modelled as depending on the stock of cumulated discoveries, whereas the method of Repetto et al. can be derived from a model where these expenditures are a function of the total stock of resources. Hamilton (1995, p. 64) shows that modelling discovery expenditures being dependent on the resource stock leads to higher genuine savings than if expenditures depend on the stock of cumulated discoveries. In comparison, the method of Repetto et al. seems to lack direct intuitive appeal. Whereas there does not seem to exist a good reason for assuming that exploration costs depend on the total stock of a resource, it makes much sense to assume that resource exploration costs depend on the stock of past discoveries as the World Bank s method does. This is because later discoveries should be more expensive than earlier ones if the easy to find reserves are discovered first which we would expect in a dynamic optimisation framework. On the other hand, the two methods are obviously linked since resource discoveries both increase the stock of past discoveries and the resource stock. Overall I would say that on theoretical grounds there are more good reasons in favour of the World Bank s method. The El Serafy -method, on the other hand, can be argued to be superior to the Bank s method. This is for three reasons: one is that it is not derived from a dynamic optimisation model. None of the data the Bank uses are guaranteed RESOURCE ACCOUNTING IN MEASURES OF UNSUSTAINABILITY 265 to be the ones that would be generated if a country
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